Robinhood, “an introducing broker-dealer that provides commission-free trading to retail customers through its website and mobile applications,” recently agreed to pay a record-setting amount of $70 million — consisting of a $57 million fine and more than $12.5 million in restitution to 2,832 customers — to resolve a myriad of FINRA rule violations dating back to 2016. While the lengthy Letter of Acceptance, Waiver, and Consent No. 2020066971201 (“AWC”) reads like a final exam in a corporate compliance and securities regulation course, there are two key takeaways that merit particular emphasis. First, an overreliance on technology without sufficient safeguards or personal verification can create substantial liability. Second, making claims about new, nontraditional products being offered directly to customers can be deceptive or misleading and in violation of FINRA Rules 3110 and 2010, if FINRA determines the communications lack sufficient disclosures.
Overreliance on Technology
As a FinTech company — and a very successful one — it is no surprise that Robinhood’s operations were heavily reliant on a variety of different technologies to provide services to its customers, including proprietary software and customer-analysis algorithms. This reliance on technology allowed Robinhood to grow rapidly without having to make the same expensive investments in personnel, real estate or other costs that traditionally accompany growth at other financial service companies. However, that rapid, technology-driven growth did not come without risks; and as the AWC makes clear, many of those risks translated into real problems for Robinhood and its customers.
First, Robinhood relied on an almost fully automated system to approve customers for the options trading program offered by the firm. These “option account approval bots” were algorithms designed to determine whether customers had the requisite level of experience and risk tolerance to make options trading appropriate for them. However, the “approval bots” had obvious flaws and could be easily fooled. For example, a customer could apply based on certain information and be denied for options trading, and then apply minutes later with different, inconsistent information and get approved for some level of options trading. To make matters worse, for years Robinhood’s human review of these applications only covered 20 applications a week. More recently, Robinhood increased the human review to 500 applications a week, but those reviews are confined to determining whether the “approval bots” functioned correctly, and do not independently evaluate whether the applicants should qualify for options trading. More generally, Robinhood did not have any employees whose primary job responsibilities related to customer identification; and during a period of time that a single principal at the company approved more than half of the 5.5 million new customer accounts that were opened.
Second, Robinhood failed to appropriately supervise its technology infrastructure and to ensure that it was sufficiently prepared for its substantial growth, extreme market conditions and potential outages. Robinhood experienced numerous outages, one of which was caused by a single, overloaded system that had a domino effect on the rest of Robinhood’s platform. Less than a week later, Robinhood suffered another outage when an update to their systems was implemented before being properly tested; and the update caused the order-entry system to shut down for approximately 45 minutes. A major problem with Robinhood’s setup was that it outsourced the operation of its website and mobile apps to its parent company without adequately supervising them. This lack of supervision was particularly problematic because Robinhood had written procedures in place that required individuals at Robinhood to supervise those technology functions; but nobody was ultimately responsible for implementing them — and nobody ever did.
Third, Robinhood’s systems and its trading app — its key interface with many of its customers — were improperly designed for the goal of preventing customers from trading on margin when they either opted out of margin trading, or only possessed a more limited type of account that should have prevented them from using margin under any circumstances. This technology failure resulted in more than 818,000 customers being permitted to trade using margin when their account type or individual election should have prevented that from happening. As the AWC specifically notes, this included the tragic case of a 20-year old customer who took his life after believing that he lost more than $700,000 using margin as a part of a transaction despite opting to turn margin “off” on his account. Robinhood recently settled a civil lawsuit filed by the family of the young man who lost his life.
Fourth, Robinhood’s technology also failed in multiple ways to display accurate information to its customers. In one instance Robinhood displayed inaccurate cash balances and “buying power” calculations to a certain subset of its customers. In another instance, Robinhood displayed incorrect historical performance figures to customers because they failed to account for cash dividends and other cash movements and transactions. In a third example, Robinhood systems displayed incorrect information to customers for more than four years because Robinhood failed to timely process corporate transactions like stock splits, dividend payments and various M&A activity. Robinhood’s failure to have appropriate systems in place to monitor and check the information it was communicating to its customers ultimately impacted millions of its customers and was a major component of the FINRA rule violations underlying the AWC.
Compounding all of the above-described problems was the fact that Robinhood’s business continuity plan was inadequately designed to address technology-related emergencies. Instead of taking into account all of the potential types of contingencies that could impact Robinhood’s operations, the business continuity plan only meaningfully addressed potential physical disasters that prevented the use of Robinhood’s offices. Another fundamental problem was that Robinhood based its plan on a template for “small introducing firms,” despite the fact that it had grown into a much larger and more sophisticated operation than the template plan it was using contemplated. In 2015 Robinhood had fewer than 500,000 customers. Today, although it only has 770 registered representatives and 6 branches it has 31 million customers.
“Commission Free Investing,” “Free Stock” Incentives and Other Problematic Promotions
While Robinhood’s technology-related failures were substantial and involved many different aspects of its operations, FINRA also cited Robinhood for a variety of misleading claims that it made in promotions, marketing, and other communications with customers and potential customers.
In an understandably popular and eye-catching promotion, Robinhood sought to attract new customers by offering free shares of stock as an incentive to get new customers to open accounts. While it was true that Robinhood would give free shares of stock to members of the public who opened accounts as a part of the promotion, Robinhood failed to disclose that there was a 98% chance that the free stock would only have a value of $2.50 to $10.00. Instead, the promotional materials misleadingly touted the possibility that new customers would receive shares in companies that were significantly more valuable, like Apple.
In a second episode of marketing efforts gone awry, Robinhood was cited for it much-criticized aborted launch of its “Checking & Savings” program. Harnessing the power of viral marketing and its large existing customer base, Robinhood saturated social media and its customers’ inboxes with promotional materials for a new checking and savings product in December 2018. Though the product was shut down only one day after it was announced, the marketing campaign was so successful that it resulted in almost 1 million customers signing up for early access to the product. However, the promotional materials for the program had a number of critical flaws, including: (1) touting SIPC coverage for the accounts despite not having that coverage; (2) improperly equating the “Checking & Savings” branding with a bank deposit account; and (3) offering a seemingly guaranteed interest rate of 3%, but which was actually a variable rate that was contingent on other benchmarks.
Finally, FINRA took issue with Robinhood advertising the fact that it had “commission-free investing” without also making adequate disclosures about other fees and expenses that could apply to the purportedly “commission-free” trading activity. Robinhood also erred in advertising its “fractional share investing” capabilities to potential customers, because the fractional share investing program had many more terms and conditions that were not prominently disclosed as a part of the promotional materials.
The record-setting nature of FINRA’s settlement with Robinhood may have been what grabbed the headlines, but the true story as we see it is twofold.
First, while utilizing emerging technologies, increasing connectivity with customers, and offering new and exciting financial products can help companies gain attention and market share, there are substantial risks to proceeding down such a technology-dependent path. As the Robinhood example makes clear, it is essential to mitigate these risks by ensuring that these systems function as advertised, are reliable, are being properly monitored and supervised, and that there are contingencies in place to deal with potential problems quickly and accurately.
Second, whether you are offering traditional products and services to clients and prospects, or you are pushing to offer the latest and trendiest financial products, your disclosures about your offerings must be comprehensive, clear and give a complete picture of all of the associated risks. Whether big or small, well-established or emerging, every financial services company should heed the warning of Robinhood’s cautionary tale, especially in light of the new standard of care established by Regulation Best Interest.